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FRM Part II · FRM Exam Part II · VaR Mapping

A risk manager maps a long 1-year forward contract to buy euros against US dollars into its basic building blocks for VaR purposes. Which decomposition is correct?

A long forward to buy euros maps to a long euro zero-coupon bond plus a short USD zero-coupon bond, both maturing on the forward date. The euro leg is received and the fixed USD leg is paid, so the position carries FX risk and exposure to both interest rates.

  1. ALong a euro-denominated zero-coupon bond maturing in one year, and short a USD zero-coupon bond maturing in one yearCorrect
  2. BShort a euro-denominated zero-coupon bond maturing in one year, and long a USD zero-coupon bond maturing in one year
  3. CLong the euro spot rate only, with no interest rate exposure
  4. DLong a euro zero-coupon bond and long a USD zero-coupon bond, both maturing in one year

Explanation

A long forward to buy euros receives euros at maturity and pays a fixed USD amount. This equals a long euro zero-coupon bond (exposed to the EUR/USD rate and the euro interest rate) and a short USD zero-coupon bond (exposed to the USD interest rate). Reversing the signs describes a short forward. Ignoring the bonds omits two interest rate risk factors.

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